Tuesday, November 18, 2008

Monetary Policy Instrument #1: the Required Reserve Ratio

Monetary Policy Instrument #1: the Required Reserve Ratio

The most powerful, but least used, instrument of monetary policy is the required reserve ratio.

Lowering the required reserve ratio increases the money supply (expansionary monetary policy).
· If the Fed decreases the required reserve ratio, banks will be required to keep a smaller percentage of their deposits in the form of required reserves.
· Consequently, banks will be allowed to loan out more when the required reserve ratio is smaller.
· More loans mean the money supply is larger.
· A larger money supply means interest rates decrease.
· Lower interest rates encourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Increased investment (I) & consumption spending (C) mean increased aggregate demand. (AD = C + I + G + X - M)
Raising the required reserve ratio reduces the money supply (contractionary monetary policy).
· If the Fed increases the required reserve ratio, banks will be required to keep a larger percentage of their deposits in the form of required reserves.
· Consequently, banks will not be allowed to loan out as much when the required reserve ratio is higher.
· Fewer loans mean the money supply is smaller.
· A smaller money supply means interest rates increase.
· Higher interest rates discourage investment spending by businesses and consumer spending (especially on large items, such as houses and cars).
· Reduced investment (I) & consumption spending (C) mean reduced aggregate demand. (AD = C + I + G + X - M)

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